Regulating the Banks?

The large US financial institutions were major recipients of government bail-out money in 2008/9 – bailout money that cumulatively came to a staggering $17.5 trillion – and in consequence they also became in 2008/9 a major target of both public censure and politically-inspired reform. The public largesse to them – predicated on the belief that a major bank failure would generate too much collateral damage in the real economy and that according certain banks at least were “too big to fail” – produced unprecedented levels of public subsidization. By August 2009, Citigroup had received $397.9 billion in federal bailout monies, AIG $254.6 billion, Bank of America $101.8 billion, JP Morgan Chase $94.7 billion, Goldman Sachs $63.6 billion, Wells Fargo $36.9 billion, and Morgan Stanley $35.0 billion (The Nation, October 12 2009). In May, policy was expanded to enable public funds to flow as capital infusions into six major insurance companies too: Hartford, Prudential, Lincoln National, Allstate, Ameriprise and Principal Financial Group.

Three features of this bank bailout stand out as particularly significant

Guilty Parties Still in Play Much of the money was going to institutions whose enthusiasm for mortgage-backed securities had triggered the crisis in the first place. The Center for Public Integrity published a report in May 2009 (John Dunbar, The Roots of the Financial Crisis: Who Is to Blame?) that found that “at least 21 of the top 25 subprime lenders were financed by banks that received bailout money – through direct ownership, credit agreements, or huge purchases of loans for securitization”; that 20 of the top 25 had now closed; and that 11 of them had made settlements to settle claims of lending abuses. Citigroup and AIG were among the eleven; Lehman Brothers, Merrill Lynch, Goldman Sachs, JP Morgan Chase and Citigroup were among the original twenty-one. JP Morgan Chase, for example, paid the SEC over $700 million in November, and agreed to forfeit $647 million in fees to settle federal regulators’ charges that it bribed [public officials to win municipal bond business in Jefferson County, Alabama! Richard Posner cast the net even wider in his “Financial Deregulatory Reform: The Politics of Denial”, The Economists’ Voice, www.bepress.com/ev November 2009: pointing to the role of the existing Treasury and Fed leadership (Geitner, Summers and Bernanke) as supporting players in the lax monetary and regulatory regimes of Greenspan, Bush II and Clinton that had laid the groundwork for the crisis in the first place. Add to that the report of the inspector general for the TARP program – also in November – criticizing Treasury officials for not demanding more reforms from the bankers the TARP money saved from bankruptcy (On this, see Paul Krugman, “The Big Squander”, The New York Times November 20 2009); and much of the ban bailout looks like a missed opportunity for a state-designed corralling of a financial system out of control.

Centralization and Concentration of Capital With TARP help, some of the major banks bounced back into profitability while others did not; and those that did quickly tried to return public money, to free themselves from the restrictions (particularly on CEO remuneration) that came with the money. Goldman Sachs reported profitable results as early as the first quarter of 2009, and was one of four bank holding companies (American Express, JP Morgan Chase and Morgan Stanley were the others) given permission by the Treasury in June to begin paying back the public money they had been lent. Other large US financial institutions and smaller banks fared less well. Citigroup and Bank of America continued to struggle with the burden of consumer debt they carried (both making a loss in the third quarter as Goldman Sachs and JP Morgan Chase made significant profits again); and both Morgan Stanley and Wells Forgo continued to be adversely affected by the ingoing problems of the commercial estate market in which they were heavily committed. At least their size protected them from total bankruptcy – Morgan Stanley was back in profitability in October – but not so smaller banks like the Colonial BancGroup of Alabama that failed in August, one of more than 100 US banks to close their doors in 2009 at an overall cost to the FIDC (charged with honoring their debts) of more than $50 million (its entire reserve). It was the big banks who grew through this crisis. Federal data issued in August demonstrated that JP Morgan Chase, Bank of America and Wells Fargo now each holds more than $1 in every $10 deposited in US banks; and that in 2009 the three banks and Citigroup (one-third government-owned) together issued one in every two mortgages and two in every three credit cards. Bank of America, Wells Fargo and Citigroup began to pay back their TARP money in December. (The Washington Post, August 28 2009)

Wall Street Against Main Street Bank profits helped take the Dow through the 10,000 barrier again in October, demonstrating a return to health – however precarious – of the biggest players in the US financial system, a health that was however sadly still missing in the wider economy on which generalized job creation depends. And it was missing there because major US banks remained slow to dispense in the form of credit to the wider economy the public funds that had bailed them out so dramatically less than a year before. They were slow, but they claimed they were active. The TARP watchdog reported in July that the majority of US banks claimed that bail-out money had allowed them to increase their lending to customers, and a minority reported they had used the money to buy up rivals. “43% said they had bolstered their capital cushion, 31% made other investments – such as mortgage backed securities – 14% repaid debt and 4% made other acquisitions.” (The Financial Times July 20 2009).You might be forgiven for expecting that an administration so generous with bank bailout money could command bank obedience, but you would be wrong. As late as December 15 2009, the President was still urging the banks to take “extraordinary measures” to revive lending to small businesses and homeowners, and condemning the next round of bank bonuses, but to no avail. Clearly there was no swift movement from bank bailout to exploding lending – Wall Street’s recovery did not immediately trigger Main Street’s revival: and for good reason.

“Instead of being dropped by helicopter, cash is injected into banks that have a thousand reasons for not passing it on. Stimulative monetary policy is not black magic. It works by encouraging business investment or personal borrowing. But…consumers are now anxious to reduce rather than increase their debts; and we are not likely to see a western investment boom sufficient to offset Asian surpluses when the economic mood is so pessimistic.” (Sam Brittan, ‘Simple truths about the economy”, The Financial Times November 13 2009)

With the return of bank profitability came the return of the issue of bonuses – the issue that had so offended middle-America (and the man soon to be president) at the height of the financial meltdown in September/October 2008. In spite of a direct appeal for moderation from the new president in March, and again speaking on Wall Street in September, by year’s end Goldman Sachs was proposing to dispense a record $23 billion in bonuses. Senior staff at the top six banks were expected to receive bonuses totaling $70 billion in 2009! The new administration did appoint a pay czar, charged to moderate CEO compensation packages in firms in receipt of public funds; and 2009 did see a number of such rulings. But the scope of the pay czar’s reach was extremely limited – though it did stretch to the Bank of America’s departing CEO – and even AIG could not be prevented, for all the $170 billion bail-out it received, from making bonus payments to its senior staff of $165+ million. (The House passed a bill to tax those at 90%) Not surprisingly, reports were circulating in the financial press by September of developing Fed and Treasury plans to limit executive compensation in the largest (top 20) US financial institutions (see, for example, The Wall Street Journal, September 18 2009): plans due to be made public before Thanksgiving. Perhaps more surprisingly, the CEO of Goldman Sachs was on record by November defending the role of CEOs and companies like his as not simply “very important” but also as actually “doing God’s work”! (This, in an interview in London’s Sunday Times, November 8)

In the event, Goldman Sachs decided to restructure their bonus payments along lines suggested by the administration: their top people receiving bonuses in company stock that would only rise in value if the company prospered, and which could only be sold after a fixed period of time. But then, Goldman Sachs did prosper, and continues to do so; and AIG executives, for their part, may have promised the New York Attorney General in March that they would return their 2008 bonuses – but by December had largely failed to do so! (see The Washington Post, December 23 2009 for details) The Wall Street Journal estimated in January 2010 that the top 30 major US banks and securities firms were on target to award staff 4145 billion in bonuses in 2009, up 18% from the previous year. (The Wall Street Journal, January 15 2009) With unemployment outside the financial sector still high, the contrast between such Wall Street largesse and Main Street recession prompted the President in January 2010 to condemn the planned bonuses as ‘obscene”, and to propose a $90 billion bank levy over a 10 year period on the top 50 financial institutions to dent excess profit taking, particularly by the largest financial institutions. The plan called on the biggest four bank holding companies to pay back at least $1 billion each in 2010. “We want our money back, and we’re going to get it”, the President said, and “I urge you to cover the costs of the rescue not by sticking it to your shareholders or customers or your citizens but by rolling back bonuses.” According to The Financial Times, Treasury officials “regard the levy as having some of the elements of a windfall profit tax. While there was no expressed intention to penalize specific firms….its burden will fall proportionately heavily on investment banks that have rebounded much more rapidly from the crisis than regular commercial banks.” (FT, January 15 2010)

The difficulty of containing the use of bonuses points to the biggest political problem in relation to the financial sector that surfaced in 2009, namely how – if at all – to make good on the promise to more tightly regulate banks and other financial institutions. The choices before the administration were broadly three fold: (a) to do nothing, treating the crisis as a product of a few rogue dealers and the inadequate application of existing regulations; (b) accepting the inevitability of a financial landscape dominated by institutions too large to fail, and finding ways to prevent their future instability; or (c) taking this opportunity to fundamentally reconfigure that landscape by breaking up the largest conglomerates and restoring the firewall between housing finance and the rest of the credit system. View ‘a’ was largely that of the banking industry leadership, except for the odd central banker (the UK’s Mervyn Kind in particular, and the US’s Paul Volker) who favored solution ‘c’. The present chairman of the Federal Reserve, and the Democratic Party’s Barney Frank, joined Treasury Secretary Tim Geitner in holding to the middle ‘b’ position. In the wake of the unexpected loss of Senator Edward Kennedy’s old Senate seat in a special election in late January 2010, however, the White House suddenly changed course, moving from ‘c’ to ‘b’. Taking his cue from Paul Volker rather than Tim Geitner, the President called for a ban on banks also “owning, investing in or sponsoring” hedge funds and private equity groups. “Never again,” he said, “will the American taxpayer be held hostage by a bank that is too big to fail”; and banging a populist drum, he made clear he wanted bank all the taxpayer money that had saved the financial system from generalized collapse in 2008. 2010 began with the President calling for a return to financial architecture similar to that created by Glass-Steagall in the 1930s, architecture deconstructed when Bill Clinton was president and Larry Summers was Treasury Secretary. It remains to be seen how sustained that change of line will be, and how influential it is as Congress re-writes the rules on financial regulation through 2010.

The Geitner toxic assets plan, announced in March 2009, proposed that the Treasury would help finance a series of public-private investment funds to buy up unwanted mortgage-based securities, with the Treasury lending as much as 85% of the purchase price, plus a matching dollar-for-dollar contribution to cover the remaining 15%. The Treasury anticipated buying up between $500 billion to $1 trillion worth of such toxic assets. The Geitner regulatory plan initially proposed the establishment of a single regulatory agency (he reportedly favored the Fed for this role), more conservative capital requirements for major institutions, the forcing of large hedge funds and private equity firms to register with the SEC, new regulation of derivative markets and strengthened requirements for money market funds. The Geitner answer to the request for an inquiry into the causes of the financial meltdown was the development of a stress testto establish the financial viability of 19 major US banks. The test found 10 of them needing to raise a total of $75 billion in extra capital, and gave the rest a clean bill of health. Among those ordered to strengthen their asset base were Bank of America, Wells Fargo, Citigroup and GMAC, the financing arm of General Motors.

The Geitner Public Private Investment Program has been heavily criticized as too generous to the Wall Street institutions that created the financial tsunami in the first place, and too costly to the US taxpayer (see, for example, Joseph Stiglitz, “Obama’s Ersatz Capitalism”, The New York Times, April 1 2009). Enthusiasts for splitting the toxics off into a ‘bad bank” were particularly incensed (see, for example, Jeffrey Sachs, “The Geitner-Summers Plan is Even Worse than We Thought”, The Huffington Post, April 6 2009). Enthusiast for nationalizing insolvent banks were equally dismissive (see, for example, Andrew Rosenfeld, ‘How to Clean a Dirty Bank”,The New York Times, April 6 2009, or “Geitner Must Go”, The Nation,April 13 2009). But time alone will be the judge of whether, as the assets are sold, tax revenue is ultimately lost or gained. (For the argument that it might very well work, see Cyrus Gardner, ‘Taking the Toxic Out of Assets”, The New York Times, June 9 2009) By December the Us Treasury was reportedly anticipating that it would eventually recover all but $42 billion of the $370 billion it had lent out to ailing companies since the crisis began, with the part lent to banks actually yielding the tax payer a slight profit (see The New York Times, December 7 2009 for details)

The Obama administration’s proposals on how to regulate the derivative markets were published in mid May 2009, part of an avalanche of legislative proposals to tighten supervision of American financial institutions. New limits on the marketing and charging of credit cards were signed into law late in May 2009. By early summer, the administration had retreated from its initial enthusiasm for a single regulator, preferring instead to add new levels of regulation on top of the existing structure as it discovered the defensive political power and propensities for turf war of first one existing regulatory body and then another one (on this, see Stephen Labaton and Edmund Andrews, ‘AS US Overhauls the Banking System, 2 Top Regulators Feud”, The New York Times, June 14 2009). The full proposals were published as an 88 page document on June 17. (For the full text of the Obama Administration plan, see

The plan gave the Federal Reserve greater supervisory authority over large financial institutions whose problems pose potential risks to the economic system. No more “shadow banking system”. It expanded the reach of the FIDC to seize and break up troubled financial institutions. It created both a council of regulators, led by the Treasury Secretary, to fill in regulatory gaps, and a Consumer Financial Protection Agency charged to live up to its name. But it said nothing about excessive bonus payments, and restricted its requirement that lenders hold on to the mortgages they create to only 5% of their value.

It was left to 1500 popular protesters in Chicago in October to let senior bank executives know how generally unpopular Wall Street remains. It was left to Senator Dodds to champion the cause of the single new regulator other than the Fed, which he did in legislation generated from his Senate Banking Committee in November. The Obama administration was quick to indicate its lack of support for the Dodd proposal (The Wall Street Journal, November 14 2009). All was still in play on this as we approached publication date for Answering Back. The Senate will not get round to legislating until the spring of 2010, but the House has been quicker. In December it voted 223 to 202 for legislation to create a strong Consumer Financial Protection Agency, to regulate a portion at least of the market for derivatives, to require large financial firms to contribute to a fund to help dissolve in an orderly fashion institutions too big to be allowed to fail without support, and to limit executive compensation packages. Barney Frank, the measure’s main architect, insisted that if implemented, “we have a set of rules in place that will allow the most productive parts of the free market economy, and particularly the financial system, to play the role they should play; but with much less chance of abuse.” (quoted in The New York Times, December 12 2009)

DEVELOPMENTS IN 2010

2010 began with some fairly awful bank news

• Bank lending in the last quarter of 2009 fell more sharply than at any time since 1942! “Besides registering their biggest full-year decline in total loans outstanding in 67 years, US banks set a number of grim milestones. ….US banks at risk of failing hit a 16-year high at 702. More than 5% of all loans were at least three months past due, the highest level recorded in the 26 years the data have been collated. And the problems are expected to last through 2010. FDIC Chairman Sheila Bair said banks are ‘bumping along the bottom of the credit cycle’ and that the number of bank failures in 2010 will likely eclipse the 140 recorded last year.” (The Wall Street Journal, February 24, 2010)
• Wall Street bonuses, by contrast, topped $20 billion in 2009, up 17% on 2008! (The Financial Times, February 24, 2010). At least AIG employees agreed to a cut in their bonuses, Bank of America phased its bonuses in over three years, paid mainly in stock, and Goldman Sacks paid its CEO (Lloyd Blankfein) just a $9 million bonus in 2009, as against a $68.5 million payout in 2007. Still, unbelievable numbers in an economy wracked by unemployment and poverty.

The Obama administration toughened its own reform demands early in 2010, as Paul Volker visibly replaced Tim Geithner as the major voice on this in administration circles. The so-called Volker rules, much resisted in the Senate, proposed separating commercial banking from proprietary trading (trades made for the benefit of the bank, not its customers), so forcing an institution like Goldman Sachs to choose between its newly acquired status as a bank and its possession of proprietary trading desks and private equity units. If it remains bank, it will enjoy federally insured deposits, but it will not be allowed to own a division that makes speculative bets with its own capital. The administration also proposed blocking mergers that would give any one company more than 10% of all liabilities in the financial system; and a levy of 0.15% on any bank balance sheet of more than $50 billion.

Senate banking committee chairman Christopher Dodds followed that in March with a 1336 page bill of his own creating a nine-member council, led by the Treasury Secretary, to watch for systemic risks, and to direct the Federal Reserve to supervise all the major interconnected financial institutions, not just the banks. The bill included the Obama ban on proprietary trading by US banks, and a new Consumer Financial Protection Bureau inside the Fed. The bill faced the near certainty of a Republican filibuster in a tightly-run election year.

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Alex Berenson perhaps deserves the final word, writing in The New York Times on the first anniversary of the crisis.

“One year after the collapse of Lehman Brothers, the surprise is not how much has changed in the financial industry, but how little. Backstopped by huge federal guarantees, the biggest banks have restructured only around the edges. Employment in the industry has fallen just 8 percent since last October. Only a handful of big hedge funds have closed. Pay is already returning to pre-crash levels, topped by the 30,000 employees of Goldman Sachs, who are on track to earn an average of $700,000 this year. Nor are major pay cuts likely…executives at most big banks have kept their jobs. Financial stocks have soared since their winter lows. The Obama administration has proposed regulatory changes, but even their backers say they face a difficult road in Congress. For now, banks still sell and trade unregulated derivatives, despite their role in last fall’s chaos. Radical changes like pay caps or restrictions on bank size face overwhelming resistance. Even minor changes, like requiring banks to disclose more about the derivatives they own, are far from certain….Regulators and lawmakers have spent most of the last year trying to save the financial industry rather than transform it.”

Or again, Martin Wolf in The Financial Times September 30 2009-11-13

“What entered the crisis was, we now know, an ill-managed irresponsible, highly concentrated and undercapitalized financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalized financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead”

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